In the late 1990s, managers of clothing boutiques began freshening up the inventory in their stores every few weeks. The accelerated turnover—quite hefty compared to the industry standard of three to four times a year—spurred them to place increased importance on metrics that could help them produce the best business performance.
The boutiques, which had solid deals with manufacturing sources, were able to respond to customer feedback and deliver new products within two weeks. “The Zaras and H&Ms of the world, small specialty stores, became very nimble,” recalls Sue Welch, chief executive officer of TradeStone Software, a company that develops programs for store buyers. “Department stores were caught flat-footed,” said Welch.
To compete, the big outlets had to switch to equally frequent changeovers of the goods on their racks. As a result, the finance chiefs of the entire industry became focused on inventory turnover. The metric refers to the fraction of a year that an average item remains in inventory or, equivalently, to the ratio of a company’s annual sales to its inventory.
In the latter case, a turnover rate of zero means that a company is unable to sell its entire inventory in a year, a sure sign of inefficient sales performance. “If the turnover number goes too low, it adversely affects our working capital and we have to borrow money to cover the excess inventory,” says Andrew Demott, CFO of Superior Uniform Group, a wholesale apparel company whose customers are hospitals, grocery stores, and other businesses with uniformed workers.
If purchased inventory stays in the warehouse for too long, it soaks up financial resources that could be put to work, for example, in earning interest, he explains. Further, if the need for warehouse space increases, so do those costs.
If, on the other hand, the inventory-turnover ratio is too high, it’s likely that desired goods wouldn’t be on the shelf, according to Demott. That might cause a customer to shop elsewhere.
The metric hooks into measurements of the overall health of a company. “Inventory turnover is critical to us because that directly translates back into how much cash we have on the books,” the Superior Uniform executive says. The turnover ratio for the company is about 180 days or two times a year, which means it takes six months to sell all of its inventory.
The relatively low turnover stems from the employee churn rate at client companies, which drives the need for new uniforms, explained Demott. Another reason is that the company keeps excess inventory on the shelf to meet customer demands while the uniforms are being shipped to the company from far-flung offshore sources. About 75 percent of the uniforms come from Central America and 15 percent come from Asia.
To be sure, the pressure for fast turnover is much greater for apparel retailers, which have seen the need for speed triple in the last decade. But the strain affects the entire supply chain, including distributors, transporters, storage-facility operators, and suppliers as well as retailers.
In recent years, the speed of moving goods through the entire apparel supply chain has shortened from 360 days to 90 days or less, according to Welch. “It is a huge strain on getting new product designed, developed, and delivered,” she says.
Speed, however, isn’t everything. Another important metric in the apparel industry is dilution to gross margin stemming from item markdowns and returns. Susan Ding, a credit analyst at Standard & Poor’s, looks at the measurement to get a sense of how well a company sells items at their full prices. The metric can suggest whether the company is producing the right goods for its consumers, she added.
Dilution is usually expressed as a percentage of gross sales, and the average mark in the apparel industry ranges from 5 percent to 20 percent. Ten percent or less is considered a good number, said Ding.
Since companies don’t tend to report dilution numbers in their financial statements, the analyst acquires them directly from apparel makers on a monthly or quarterly from companies. The upside of reporting the metric is that if a company can “manage dilution to a minimal level or improve it year-over-year, that is considered a favorable event,” the analyst explained. “The smaller the dilution, the more sales they can recognize.”